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In an interview with Knowledge@Wharton one year ago, Michael Dell declared his support of then-CEO Kevin Rollins, indicated that supply chain efficiencies and direct sales gave the company a competitive edge, and added that his namesake company was making great strides in customer service.

What a difference a year makes. Michael Dell took over the reins from Rollins on January 31 — taking back the role of CEO — and set out to remake the $57 billion Round Rock, Tex., PC manufacturer. Starting in June, Dell began to complement its direct sales model by selling PCs through Wal-Mart and Sam’s Club stores. The company has since courted consumers with laptops in a range of colors including “midnight blue,” “flamingo pink,” “spring green” and “espresso brown,” but consumers who have ordered some of these colorful models have experienced delays due to supply chain problems related to producing the different hues in volume.

Dell’s retooling comes just as it has lost its worldwide market share lead to Hewlett-Packard. According to research firm IDC, HP had a worldwide PC market share of 19.3% for the quarter ending June 30 compared to Dell’s 16.1%. In 2005, Dell dominated the playing field with 18.2% market share compared to HP’s 15.7%.

On the plus side, Dell has put to rest some of its nagging problems. On August 17, the company concluded a year-long financial audit, saying that it had discovered “numerous accounting issues” which “appear to have been motivated by the objective of attaining financial targets.” As a result, Dell will restate the last four years of financial results. A Securities and Exchange Commission investigation of Dell’s accounting practices is still underway.

Analysts generally agree that Dell is on more solid footing than it was a year ago. Last month, the company reported fiscal second quarter net income of $733 million, or 32 cents a share, on revenues of $14.8 billion, up 4.8% from a year ago. Meanwhile, gross margins of 19.9% were at their highest levels since the year 2000 due to lower prices for parts, including memory, displays and batteries.

But questions remain about Dell’s turnaround. According to some Wharton faculty, Dell’s biggest challenge is that the two pillars of its business model — supply chain efficiency and direct build-to-order sales — don’t provide the advantage they once did. Indeed, Hewlett-Packard is a much stronger competitor than it has been in the past, and Acer, a Taiwan-based PC manufacturer, announced plans to buy U.S. PC vendor Gateway on August 27. Once the acquisition is finalized, Acer will become the third-largest computer maker in the world. These competitors have closed in on Dell’s supply chain edge.

And finally, Dell hasn’t historically targeted its products to consumers — a segment that has generated most of the growth and innovation in the technology industry in recent years. In July, CEO Michael Dell said at a product launch that the company will have to become savvier about product design to woo consumers who increasingly see technology products as fashion accessories. “We are kind of in the fashion business. We have been putting quite a bit more energy into this. It will be reflected in future products,” Dell stated.

“Dell’s success has been, ‘You tell us what you want and we will build it for you,’” says Christian Terwiesch, an operations and information management professor at Wharton. “That approach has worked well with corporate [information technology] people and professional users. But that is a cut-throat market since these people have a good knowledge of prices. Dell has always had a hard time with the non-expert buyers.”

Terwiesch notes that there are only so many technology buyers who value picking out a specific video card and other components in a computer. And in order to compete with rival HP, Dell has to find new customers. On August 16, HP reported fiscal third quarter earnings of $2.1 billion on revenues of $25.4 billion, up 16% from the same quarter a year ago. HP also projected its annual revenues for the year ending October 31 at between $103 billion and $103.2 billion. Wall Street analysts expect Dell to report revenues of about $60 billion for its fiscal year ending January 30, according to Thomson Financial.

HP CEO Mark Hurd said on a conference call following the announcement of the company’s earnings that HP is “executing on the plans we have laid out, delivering on our commitments to customers and investors, and effectively balancing our growth, investments, and cost reduction opportunities.”

According to experts at Wharton, Dell has been refashioning itself largely to compete with HP which, under Hurd, has become more efficient. HP has also leveraged its relationships with retailers to better target consumers, which have been fueling PC sales. The big question is whether Dell can take the best parts of its current business model and mesh them with new initiatives.

For Dell, most of its new initiatives — better design, expanding retail sales and courting consumers — take the company into uncharted waters, says Nicolaj Siggelkow, a management professor at Wharton. “Dell has really strayed from its original positioning. Is the refocusing going against what made Dell successful?”

Sergeui Netessine, an operations and information management professor at Wharton, wonders whether Dell can truly change its model, but notes the company doesn’t have a choice. “Dell focused solely on its supply chain, but Apple reminded consumers that design matters. Design of a computer is not something you can forget. One way of dealing with Dell’s situation is to design exciting machines,” he says.

Dell’s Supply Chain: Less Dominant?

If product design and multiple sales channels matter, what does that mean for Dell’s supply chain focus? Netessine has some rough numbers to illustrate the PC maker’s declining supply chain edge. In 1997, if Dell and HP both sold a computer that cost $1,000 to make, Dell would incur about $20 in inventory costs compared to HP’s $160. By 2005, Dell’s costs were $10 compared to HP’s $70. Dell’s advantage compared to other competitors is even smaller, says Netessine, who noted that Dell and HP aren’t totally comparable given that the latter has a large printer business, has a larger consulting service and has acquired software companies such as Mercury Interactive and Opsware.

In his interview with Knowledge@Wharton, Dell acknowledged that competitors have closed the supply chain gap, but noted that his company maintained a sizeable lead on costs. “I think that there have been some competitors that have certainly improved their supply chains. But if you look at basic metrics, like return on capital or inventory management, they haven’t approached anywhere near the level that Dell does with its supply chain,” said Dell.

Netessine agrees with that statement, but argues that Dell is approaching a point of diminishing returns. And as these returns diminish, the strengths of Dell’s rivals — HP’s retailing prowess, Apple’s product design and Acer’s low costs — present a bigger challenge. “While Dell’s supply chain advantage is still there, it’s not as big anymore,” says Netessine. “Competitors of Dell have been quite effective. Now you can build to order from any computer manufacturer.”

Meanwhile, Dell will incur more costs as it expands into retail distribution, a move that will further eat away at Dell’s cost advantage. “We expect margins to continue falling as Dell ramps its retail PC distribution,” said Clay Sumner, an analyst at Friedman Billings Ramsey, an Arlington, Va., investment firm, in a research note following Dell’s earnings announcement. “We continue to believe that [Wall Street analysts are] underestimating the costs of growing a retail channel.”

According to Siggelkow, there is also a risk that new initiatives will distract Dell from its supply chain operations. “The paint issue surprises me considering Dell’s ability to build to order,” he says. “Given the organization at Dell’s factories, this should not be a problem.”

Dell’s painting problems surfaced in late July as executives disclosed delays on the company’s Direct2Dell blog. In a post on August 3, Alex Gruzen, Dell’s senior vice president of consumer products, said the company’s “tuxedo black” laptop was the only color meeting quality standards. Gruzen likened the painting process to a custom paint job on a car.

“There was no problem painting hundreds at a time,” wrote Gruzen. “But as we increased the volume, otherwise manageable factors, like dust contamination, caused our successful yields to decrease. Adding to the complexity, the [red and white] colors require more coats of paint and more touches to create the finished product. That means there is more opportunity for dust contamination.”

Sumner estimates that “Dell failed to ship several hundred million dollars worth of notebooks in the second quarter, due to painting and supply chain issues.” The risk is that Dell’s reputation, which has been tarnished because of customer service problems in recent years, could take another hit with consumers.

A more immediate concern is HP, which could take advantage of Dell’s missteps. “Continuing shipment delays and online-ordering horror stories at Dell will likely reinforce the consumer trend of buying notebooks at retailers, playing to HP’s strength, while potentially compromising Dell’s negotiating position as it attempts to cut new distribution deals with retailers,” wrote Sumner.

Perils of Targeting the Consumer

On Dell’s blog, customers were vocal about their disappointment over the laptop delays and painting miscues. Experts at Wharton say the paint mishap coupled with a tarnished customer service reputation make it difficult for Dell to repair its image.

Terwiesch suggests that Dell may have to rethink its historical approach to consumers. Until recently, Dell courted primarily corporate customers even though it did attract technologically savvy consumers. However, for Dell to attract more consumers to its products it will have to pay more attention to design, simplify its sales by curbing the number of options it offers on PCs and provide better customer service.

Dell’s challenges “partly reflect Dell’s inability to understand the way consumers think and feel about their products,” Terwiesch says. “Dell thinks about their offerings as microprocessors, disk drives and frames-per-second graphics. But consumers just want a computer they can be proud of when they show it to their friends, listen to music, watch videos and do office work.”

To illustrate his point, Terwiesch compares the direct buying experience on Apple’s site with Dell’s. “You buy a PowerBook: That is a promise from Apple that you get a cool and great computer. Yes, you can configure it a little, but it is much more of an after-thought.”

Siggelkow points out another risk of targeting consumers — customer support costs. For instance, a corporate customer may have an issue with a Dell PC, but his first call is to his technology department. Consumers call the vendor first when they have a problem, and that increases customer support costs. “Dell is switching customer bases. I have a Dell and if there’s a problem I go to the IT department. As Dell gets more consumers, there will have to be more handholding. That’s a cost driver.”

Furthermore, the costs of targeting the consumer go beyond customer service. Siggelkow notes that Dell will have lower profit margins on products it sells through Wal-Mart. And as Dell adds more retail partners, it will have to offer incentives to encroach on HP’s shelf space in stores like Best Buy. “It’s not clear to me that Dell will get the advantages that HP has by going through retailers. It will take some time,” he says.

Despite the challenges Dell faces, no one at Wharton disagrees with Michael Dell’s blueprint. If the company is going to continue to grow and compete with HP, it has to target consumers better and expand its expertise beyond direct sales and supply chain management.

Netessine says that if Dell plays its cards correctly, it can meld retail sales with its supply chain prowess. For instance, it can use downtime in customer PC orders to manufacture models destined for retailers. “Going retail is not necessarily bad. Dell can smooth out production since demand for made-to-order computers is unpredictable. The company can manufacture PCs for a different sales channel on slower days to keep factories utilized. When Dell sells through Wal-Mart, it means lower profit margins. But as long as Dell is smart about factory idle times, it can work.”

According to Siggelkow, Dell’s biggest issue will be figuring out how to keep its increasing customer base happy. “At some point, Dell had an advantage orchestrating a supply chain. What’s unclear is what happens to the brand as Dell moves downstream to consumers. I’m not sure. Dell has to ask, ‘What’s my advantage?’ The company can make laptops more stylish, sell MP3 players, TVs, printers and cameras, but if it can’t create brand differentiation, it’s a pure cost game,” says Siggelkow. “Right now, it’s not clear what advantage Dell brings to the table.”